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Audit insights: charities - positive impacts in challenging times

Charities play a significant role in the fabric of our national life, but they are being scrutinised more closely than ever. In this Audit insight, ICAEW has collated the expert knowledge of external auditors and ICAEW specialist staff to set out a series of recommendations to help charities to demonstrate their positive impact and become more resilient and transparent.

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There are more than 167,000 charities registered by the Charity Commission in England and Wales in existence today and more than 35 million adults in the UK gave to charity in 2015, according to Charities Aid Foundation UK. However, there is a disconnect between what charities do, how they operate, and what the public thinks they do and should be managed.

To bridge this gap charities must demonstrate how they are delivering positive impact, being honest and transparent about the difference they are making and where they have not achieved their objectives. But as well as being open, charities will only succeed if they are also financially sustainable. 

In this audit insight, representatives from BDO, Crowe Clark Whitehill, Deloitte, James Cowper Kreston, Kingston Smith, KPMG and RSM, share some of their expert knowledge of the charity sector and offer unique insights into some of the key issues facing the sector.

The recommendations are directed at trustees, regulators/standard-setters, auditors, supporters/funders and commentators on the charity sector, and are equally applicable irrespective of whether a charity is audited.

How can charities demonstrate they are making a positive impact?

A succession of negative media stories has shaken public trust in charities. The failure of a few charities was unrepresentative of the charity sector. Such cases lead to an over focus on what did not work in isolated cases, while forgetting about the vast numbers of charities that demonstrate good practice and have a significant positive impact in the areas they operate. 

Charities need to be more pro-active in explaining the outputs, outcomes and impact of their work. The failure to provide this information is creating a deficit gap which is being filled with flawed commentary about cost and expenditure ratios, and reinforcing confusion over performance. Figures in financial statements are often a poor measure of the effectiveness of charities and, because charities often fail to provide other vital information and key performance indicators on a consistent basis, these figures are often used as a spurious measure of effectiveness.

To improve engagement with stakeholders charities need to be more open and discursive in their reporting.

Be transparent and accountable

Some charities do a great job of explaining their impact, while others provide only patchy information about their performance. Supporters want to know that the charities they support are having a real impact. There is an opportunity for charities to better demonstrate what is being achieved rather than focusing on costs.

This includes being honest about:

  • activities that have worked and are working;
  • activities that are not working; 
  • new endeavours that have not been as successful as anticipated; and
  • the lessons that have been learnt.

Charities also need to be less reticent about explaining that they need to spend money to raise funds and to provide the necessary infrastructure, and to explain why such expenditure is important and necessary.

However, transparency does not necessarily mean even more information. The focus should be on providing meaningful and relevant information that demonstrates a charity’s impact. Regulators and standard- setters should provide more examples of good practice and reassess their requirements to make disclosures clear, concise and more relevant.

Auditors can guide charities in cutting through some of the complexity and clutter often present in annual reports and financial statements. In our experience, although auditors have largely embraced the value that better reporting brings, there are still a number of examples where boilerplate, less specific or meaningful descriptions are used and plenty of room for improvement.

Identify the difference charity work has made

The perception of aggressive fundraising techniques, a perceived lack of accountability and transparency, alongside negative media coverage, has led to a decline in overall trust and confidence in charities, according to research by the Charity Commission for England and Wales. The challenge for all charities is to demonstrate the positive impact of their work because there is still a rich reservoir of public goodwill towards charities.

According to the research, although public trust may have declined it has had little impact on the importance that the public places on the role of charities. The public wants to see charities making a positive difference to the cause they are working for. But it is no longer enough to do good; charities must also uphold the highest standards.

Many charities already have good systems for capturing the positive nature of their work, but not necessarily the positive outcomes and impacts their work leads to. Impact measurement is often difficult and sometimes cannot be assessed in the short term. But at the very least charities should provide more information on their activities, their outcomes and an honest assessment of the impact they are making.

Charities cannot solely rely on their annual report when communicating information about the good work they do. The format of the accounts can be hard to follow and there are a multitude of other channels that are more effective in reaching donors, beneficiaries and the public. These include the use of social media and their own websites. Charities should also consider increasing the use of case studies to illustrate their achievements.

Much of the criticism levelled at charities in the media has been on support functions and the proportion of income not going directly to the cause. Such a focus is often misleading and concerns about these types of spending sometimes lead charities to make suboptimal spending decisions rather than focusing on what they need to do to succeed. This can result in charities being less than transparent about such costs rather than considering if they are appropriate and then being ready to explain them. Trustees should make clear how the charity applies its funds and how this makes a difference to their charity’s work.

How can charities retain public trust?

Running a charity is hard work and it is not always easy to achieve the intended outcomes and make ends meet. As well as raising money for a particular cause, funds are needed to pay staff salaries, bills and other general running costs. There is a strong argument for more charities to learn from their peers and other sectors: applying demonstrated methods, technologies and approaches to improve operational effectiveness.

Provide more effective leadership

Stakeholders need to understand how vital it is that many charities have paid staff as well as volunteers if they are to achieve their aims. For example, a skilled and experienced finance director can manage revenue and plan resources, allowing more resources to be devoted to the charity’s objectives. Charities face difficulties in attracting and retaining talent, and remuneration policies need to take account of this.

Effective leadership is crucial. Trustees are often chosen because of their deep knowledge of the area the charity operates in, which lowers the risk of breaches of trust, conflicts of interest or financial mismanagement occurring. However, in addition to this knowledge charities need trustees with governance, financial management, strategic and stewardship skills. 

Before taking up their appointment, all trustees should confirm they have received sufficient information about their charity and understand the responsibilities of a trustee. Trustees of charities with strong management teams need to be ready to delegate to senior management without abdicating oversight and monitoring responsibilities.

Trustees should continually evaluate the skills and knowledge that are needed on the board, with trustees, and senior management, undertaking training to meet the increasing demands of regulation, the higher expectations and the new challenges facing charities. 

Address skill gaps and diversity

Many charities still have skill gaps on their boards. The concern among charities is that fewer people are willing to volunteer to be trustees because of the perceived risks and increased regulation which demands more from them. Smaller charities are more likely to experience difficulties in attracting board members who have the collective experience and skill sets that are required to be an effective trustee board.

A number of charities have rules and structures that can prevent them from attracting all the skills they need. For example, the rules may require that the board is elected from a particular constituency and, while this can be important, it needs to be recognised that good representation is not necessarily the same as good governance. If the election process does not lead to the right mix of skills then it should be supplemented by selection.

Charities also need to ensure there are fresh perspectives on the board. Diversifying the board can boost public confidence, bring additional expertise and generate new ideas that improve the impact of a charity’s work.

Studies suggest that many trustee chairs are white and male; charities should do more to attract trustees from under-represented sections of our communities including young people, people with disabilities and members from minority groups. Those daunted by the obligations and responsibilities of trusteeship and can be nurtured into learning about the role by being co-opted on to subcommittees and panels before progressing on to boards.

Invest in vital operational areas

Trustees and management have often shied away from making investment decisions because they believe that it will impact negatively on how they are perceived. This is due to the misleading belief that charities can be measured and compared by looking at their expenditure (fundraising, staff costs) and the income raised. In reality, income is often unpredictable and not easily linked to the amount spent in a given year, plus charities differ vastly in terms of type, lifecycle stage, operational model and fundraising mix.

Cost ratios and measures of how, and where, funds are distributed are often used as a proxy for effectiveness and efficiency. The fact is that in almost all cases such measures are flawed and lead to inaccurate conclusions. Stakeholders and supporters should not focus on the percentage of charity expenses that go on administrative and fundraising costs. While ratio analysis can help charities to identify problems and serve as part of their dashboard of financial management data, they tell us very little about the impact of a charity’s work.  

Nevertheless, this belief has resulted in underinvestment in vital areas such as information technology, skills training, income generating processes and governance and management. Charities are also to blame by perpetuating the myth that reduced overheads mean the charity is more effective. This leads to a vicious cycle of underinvestment and this can actually lead to a deterioration in a charity’s performance and the resilience needed to be able to sustain effective delivery. Funders and the public need to understand that they need to contribute to and acknowledge this.

Charities should be ready to make the necessary investment in infrastructure based on what is needed rather than how it may be perceived. Expenditure decisions should be governed by what is in the best interests of achieving objectives effectively, which may require more investment in infrastructure.

Regulators and standard setters will need to do more to get this message across and to support charities in building sustainable and resilient infrastructures.

How can charities become more resilient?

Charities are operating in uncertain times and the need for effective financial monitoring of operations has never been greater. Trustees need to receive timely, relevant and accurate information frequently to understand emerging areas of concern, and have the confidence to ask challenge the information they receive if it isn’t what they need.

Charities will need to refresh strategy and planning and be ready to re-examine some of their operations and how they manage and govern themselves. In challenging and turbulent times it is often difficult to predict the future, this may require a shift from reviewing strategic plans every three or five years to a more flexible strategic framework that adapts to the shifting environment. This means regular monitoring and measurement of progress against the strategy – many organisations are now doing this monthly.

Successful charities are the ones that are innovating and are ready to seize opportunities. To do this, charities must be nimble and agile and must be ready to be courageous in their actions and planning. There will not be innovation if charities are not allowed to undertake initiatives that are not always guaranteed to succeed. 

Boards and management need to think hard about indirect, as well as direct, implications of unfolding events, new funding landscapes, changes to laws and regulations and changing stakeholder expectations. They need to take into account events beyond typical horizon planning and be ready to manage the change that may be necessary.

Manage risk effectively

Charities that are succeeding are not the ones avoiding risk but the ones that are seeking new opportunities and taking appropriate risks through effective risk management. They are re-examining every aspect of their traditional delivery model to identify new ways of driving increasing cost effectiveness, which is not always the same as cost cutting.

Charities should communicate to donors and the wider public the case for their level of reserves, to ensure that they retain their trust and confidence. Charity funds need to be spent in support of beneficiaries, and charities should be able to provide solid, considered reasons for keeping funds back as reserves and not spending them.

Trustees are usually remote from day-to-day operations and reliant to a great extent on executive management to provide them with information on the state of risk within their charity. They should have assurance that risks are being monitored and managed effectively. A culture of sound risk management should be embedded throughout charities. Trustees should also regularly review their charity’s approach to risk management.

Develop a robust reserves policy

All charities should have a robust reserves policy in place and they should critically evaluate the level of reserves they need to hold. Holding a high level of cover for risks and unforeseen events may appear sensible, but a charity will need to explain why they need to hold reserves and what their target level is.

They should also explain the longer-term trends in their reserve levels, for example over five years. This will give stakeholders a better view and understanding of the charity’s policy. The policy should also be reviewed to guide charities when they might need to draw down on their reserves. Factors that a charity needs to consider when deciding the appropriate level of reserves, include:

  • Income – how volatile is it and what is the level of income at risk?
  • Expenditure – what is the nature of their spending commitment and how easily can it be reduced?
  • The nature of the reserves – how easily can it be realised and what will be the impact of doing this?
  • How sensitive is the charity’s income and expenditure to factors which are outside its control?

Too many charities have reserves policies to justify their existing reserves rather than really considering what reserves are needed. A charity’s reserves policy should not be developed in isolation, but should be part of its risk management strategy.

While there has been guidance from the regulator on reserves policies, some trustees continue to pay lip service to the recommendations. Charities need to consider relevant guidance and how this applies to their circumstances. There is no one-size-fits-all yardstick for charity reserves but, importantly, trustees must ensure that in developing an effective and carefully thought-out reserves policy, they link it with the charity’s risk management strategy and their appetite to take risks.

How can charities maximise their resources?

Charities have been operating in a climate where government spending cuts have widely affected the sector, increasing the funding pressure on frontline services. While bigger organisations have been coping better by taking advantage of new opportunities of funding as government increases the outsourcing of public services, many smaller and medium-sized charities have struggled to shift their funding from traditional public support to new ways of working.

Be more selective in accepting contracts

Government funding has shifted radically from grants towards competitive commissioning, payment by results (PbR), pre-financing and outsourcing. But these changes have failed to create a level playing field for charities, with large organisations dominating the market for providing public services.

A National Audit Office report published in June 2015, described payment by results (PbR) as a technically challenging form of contracting that has attendant costs and risks that government often underestimates. In December 2016, the Commissioning in Crisis report concluded that current commissioning processes are a major threat to the survival of smaller charities. 

Charities are reluctant to get involved because PbR offers no guarantee of payment and will have a negative impact on cash flow. Some funders refuse to recognise the need for proper cost recoveries and are not ready to fund the support costs that are necessary to deliver the services they are commissioning.

Funders and commissioners of services need to be aware of these challenges and they need to be realistic about what it costs to deliver services. They should also recognise that they need to engage with smaller charities. This will require a rethink of the commissioning process and the awarding criteria that are being used at present.

Charities are likely to be better off bidding as part of a consortium. Funds can also be spent more efficiently if charities are able to share logistics and infrastructure. In addition, charities should be more discerning in accepting unviable contracts. The practice of winning the contract at any price can be harmful to charities and the causes they serve.

Reconsider operating models

Sourcing new funding streams to compensate for reductions in government support is one of the biggest challenges facing charities, but competition for funds is making it more difficult to fulfil this objective. Many charities rely on unpredictable income streams such as donations or legacies, which have come under pressure and in some cases are restricted in how they can be used.

New fundraising and data protection regulations will lead to significant changes in how fundraising charities interact with the public. Most charities have recognised that this could lead to reduced income and/or increased fundraising costs. These factors, combined with demographic changes, economic pressures, increasing demand and general uncertainty have led many charities to conclude that the status quo is no longer an option.

Charities need to become more proactive in identifying and seeking help with their growth and development needs. More could be done through strategic alliances, mergers and collaborative working to share costs, risks and opportunities. Furthermore, there are many aspects of good practice in other sectors that can be adopted by charities. 

Charities that keep the crucial connection to their values and their beneficiaries, while finding new sources of income and investing in infrastructure, will be the charities that are most effective. 

Charities also need to take a good hard look at processes and activities – are they being done in the right way? Are all the activities needed? Can they be done more efficiently and effectively?